Worth more than a second glance


Economic and market disruptions create both challenges and opportunities for investors, and the fall-out from COVID-19 is no exception. Indeed, while private equity secondaries are attractive through the cycle, they can be particularly so during times of dislocation – as long as investors choose carefully.

The spread of COVID-19 may have started as a health crisis, but its effect is being felt far and wide. While the initial economic pain of lockdowns was significant, it’s clear that the pandemic’s full impact has yet to be felt. Despite the difficult backdrop, public markets, for example, surged over the summer, driven in part by booming technology stocks (which have since faced a correction), but also supported by significant government and monetary policy measures put in place to cushion the blow.

Yet many of these measures will inevitably come to an end. When the tap gets turned off, we will start to see the true economic effects of the pandemic as liquidity starts to dry up.

It’s at these points in the cycle when private equity secondary investments really come into their own. A market that connects buyers and sellers in private equity fund investments, secondaries have been growing rapidly in the years since the crisis – by 20% a year between 2013 and 2019 – to reach $88bn in global deal value last year, according to Greenhill figures. And while this growth has been significant, it remains a small subset of private equity, and accounts for a steady 2% of total unrealised value.

Secondaries are attractive because they smooth the J-curve for limited partners (LPs) – investments are made part-way through a fund’s life and so the amount of time returns are in negative territory is either shorter or zero. They also allow for a faster return of capital, can offer instant diversification through exposure to a portfolio of investments and, by their nature, are largely not blind pool investments unlike primary private equity fund investments.

The kind of challenging, liquidity-constrained market we expect to see in the coming period offers knowledgeable and well positioned investors with good opportunities in secondaries investments. And this is particularly the case as the secondaries market has grown in sophistication since the last dislocation.

The market started as traditional, plain vanilla secondaries transactions that involved the purchase of an existing investor interest in one or more private equity funds, with sellers often doing so for liquidity and/or to rebalance fund exposures. However, new types of secondary have emerged over recent years. One that has seen significant growth is GP-led secondaries, in which a fund manager initiates the sale of one or more companies in a mature portfolio by rolling them into a new fund, offering existing and new limited partners the opportunity to profit from further value creation potential. We expect these kinds of specialist strategies to outperform because they are more complex than traditional secondaries deals, they rely on strong sourcing capabilities and tend to be less competitive situations.

Volume on the secondaries market has so far been low this year, but our research suggests the next 18 months will offer attractive opportunities as dislocation in pricing starts to emerge, offering buyers the chance to buy assets and portfolios at a discount to NAV. Pricing has already reduced from an average of nearly 95% of NAV for buyout and just over 75% for venture capital funds in late 2019 to 85% and 70%, respectively in H1 2020. We expect pricing to fall further: in 2009, for example, average pricing for buyouts declined to 59% of NAV and for venture capital to 68%. Opportunities will also come from distressed LP sellers over the coming period and from GPs seeking to provide their investors with liquidity as funds reach the end of their life with unsold assets. After all, company exits will become unattractive at a time when valuations will likely be declining. Further, some investors will be looking to free up capital – in a liquidity constrained environment – for investment in 2021.

And while global secondaries funds have performed well as a sub-asset class, size really matters. Smaller funds (with US$500m or less of capital) outperform other parts of the market, with a median IRR of 16.7%, versus 11.5% for mid-sized funds with between US$500m to US$1.5bn and 13.7% for large funds (above $US1.5bn). This also holds true in median multiple terms, where small funds achieve 1.52x, mid-sized 1.36x and large 1.44x[1]. This is a reflection of the fact that capital in the secondaries market has concentrated at the larger end, making for a highly competitive environment, with just six buyers accounting for 50% of transaction volume in 2019, according to Evercore figures. The smaller end, by contrast, has a larger universe from which to select deals and less capital to deploy.

Yet even at the smaller end of the spectrum, there is a high variation in returns, with only the top quartile managers generating strong outperformance; the bottom quartile, by contrast underperforms the rest of the market. Success therefore relies on selecting the best managers with a proven track record and a specialist strategy with the skills and experience to match. So while there will be highly promising opportunities to come from private equity secondaries, market expertise, knowledge and networks will be vital.

[1] Performance as of March 31st, 2020